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Long Term Incentive Plans

Do you want to set up long term incentive plans for your senior executives? Do you participate in a long term incentive plan and you are unsure what your rights are? Suzy Giele from our team at EM Law is one of the UK’s leading experts on long term incentive plans as well as other types of share incentive schemes.

Introduction

Long term incentive plans are typically used by companies to reward their senior executives with shares or cash after a period of time provided certain service and performance conditions are met.

Although they can be used by all types of companies they are typically used by listed companies who must comply with the rules of the Listing Authority and the UK Corporate Governance Code when designing these arrangements. Other regulatory requirements may apply depending on the type of business involved.

Features

Although any employee can participate it is usually only senior executives who benefit from these long term incentive plans. Non-executive directors are generally not permitted to participate.

The long term incentive is normally in the form of shares although pay outs may be in cash or a combination of the two.

The reward is applied where performance conditions are achieved over a period of time of at least one year. Typically the period is 3 – 5 years.

Rewards may or may not pay out in full once initial performance conditions are met. A retention period may be set over a percentage of the reward which only pays out following a further period of time and potentially once further conditions have been achieved, for example, the employee remaining with the company.

Increasingly, provisions are being included allowing companies to claw back rewards where, for example, it is later discovered that profits have been misstated.

Types of long term incentive plans

Nil Cost Option

This is an arrangement where the participant can exercise an option to receive shares for free. No income tax arises until the option is exercised. Subject to the conditions for exercise being met the participant can choose when to exercise the option and so benefit from triggering a tax liability at a favourable time.

Restricted Share Units

Free shares are delivered to the participant when certain conditions are met. No income tax arises until the participant becomes unconditionally entitled to the shares but an income tax liability arises at that point.

Restricted Shares

Free shares are delivered to the participant at the time that the award is made. If certain conditions are not met within a certain period the shares are forfeited. No income tax liability arises until the forfeiture conditions are lifted. Alternatively, participants can elect to pay income tax on the “unrestricted market value” of the shares within 14 days of acquisition with the result that subsequent gains are only subject to capital gains tax.

Phantom Shares

Holders of phantom share options are entitled to a cash payment usually in the event that either the company’s share value hits a certain level or the company is sold for a price above a certain level.

Typical Conditions

Usually, long term incentive plans use total shareholder return as the principal measure of performance. Earnings per share is also a widely used target.

Other performance conditions include:

  • Return on capital employed
  • Economic profit / economic value added
  • Proven reserves (oil companies)
  • Embedded value

Malus and Clawback

A long term incentive plan award may be reduced if an employee performs poorly or in the event of a downturn in the company’s performance (malus). Malus arrangements reduce awards before benefits are due.

A clawback arrangement compels the employee to pay back some or all of the benefit received because, for example, that individual is found to have committed misconduct or the company’s profits at the time of award were overstated.

Tax Treatment of Long Term Incentive Plans

Tax treatment of long term incentive plans depends on the nature of the award.

If, for example, shares are awarded on the basis of certain conditions being met then this can be analysed as either a bonus paid in shares, in which case the award is taxed as general earnings or it can be assessed as a right to acquire shares in which case the award should be taxed as a securities option.

If, for example, phantom share options are used then an employee who receives a pay-out will be taxed on the amount of cash received.

National insurance contributions (employees’ and employer’s) will normally be payable in relation to any taxable incentive plan income.

The employing company will usually be able to claim a statutory corporation tax deduction for the value of any shares delivered to participants.

For any questions you may have concerning long term incentive plans contact Suzy Giele.

Long Term Incentive Plans EM Law Suzy Giele

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